PRODUCTION FUNCTION

Relation between the physical inputs and the physical outputs of a firm

Q = f(X, Y, Z)
Q = Output per period of time of a firm
X, Y,Z = Required inputs to produce Q Output over the same period

Depends on state of technology – when technology improves, new produiction function comes

In short run, few inputs (at least one) are fixed, while others can be changed (are variable)
In the long run, all inputs are variable
TYPES OF PRODUCTION FUNCTION

1. Multiple Linear Production Function

Q = a + b1x1 + b2x2 + ....+bnxn
Q = Output, x1....xn are inputs b1...bn regression coefficients

2. Cobb-Douglas Production Function

Q = A L^αk^β
Q = Output, L = Quantity of Labour, K = Quantity of capital, α & β = parameters

3. Constant Elasticity of Substitution (CES) Production Function

Q = A[δ K^-p + (1-δ) L^-p]^1/p
δ = Distribution parameter, p = substitution parameter
FIXED INPUT – Factor inputs whose quantity does not vary with the amount of output being
produced. e.g – machinery, building, vehicles

VARIABLE INPUTS – Factors inputs whopse quantities varies with the amount of output
being produced. e.g. - labour, raw material etc.

SHORT RUN – Period of time in which at least one factor is fixed i.e. At least one factor does
not vary with output.

LONG RUN – Period of time in which all factors are variable.

In long run, distinction between fixed and variable factor disappears, because all factors
are variable
AVERAGE PRODUCT = Total product / Amount of variable factor to produce that ouput

AP = TP/L

MARGINAL PRODUCT = additon to total product due to use of opne addtional unit of
variable factor

MP = TP(N) – TP(N-1)

- both AP & MP initially rise, reach a

maximum and then decline
- AP may decline to zero and MP
may become negative
- MP exceeds AP when AP is rising,
equals AP when AP is maximum,
and is below AP when AP is calling
 Introduction
 When producing an economic product, the
supplier must decide how much of each input
to use:
 Land
 Labor
 Capital
 In particular, the supplier must examine the
relation between input and output.
 The Law of Variable Proportions

Law of variable proportions explains the behaviour of production as the proportion

between fixed and variable inputs are changed, by inceasing the quanitity of variable factor

-In a given state of technology and keeping other factors constant, addtional units of
a variable input will yield increasing returns per unit of the variable factor up to a point

- Eventually, a point is reached beyond which further additions of the variable factor will
yield diminishing returns per unit of input. Therefore, MP increases over a range of input
up to a point, after which it decreases and evenutally becomes negative
 Production Schedule Using Varying Amounts of Labor

Number Total Marginal

of Product Product
Workers (In Units) (In Units)

0 0 0
1 14 14 Stage I
2 42 28 (Increasing
3 75 33 Returns)
4 112 37
5 150 38

6 180 30 Stage II
7 203 23 (Diminishing
8 216 13 Returns)

9 207 -9 Stage III

10 190 -17 (Negative Returns)
 Production Function Using Variable Amounts of Labor

250

200
Total Production (In Units)

150

Series1

100

50

0
1 2 3 4 5 6 7 8 9 10
Variable Input (Number of Workers)
 Conclusions
 While adding units of an input (labor), the
marginal product goes through three stages:
 Stage I (Increasing returns): marginal product
increases throughout.
 This means that every additional unit increases
productivity as well as total output.
 This is shown on the graph by an increasing slope.
 Conclusions, cont.

Stage II (diminishing returns): marginal product
decreases throughout.

This means that every additional unit decreases
productivity, though total output still increases.

This is shown on the graph by a decreasing positive slope.

Stage III (negative returns): marginal product is
negative throughout.

This means that each additional unit actually decreases
total output.

a waste of money and resources.

This is shown on the graph by a negative slope.
 Conclusions, cont.
 The greatest productivity is at the end of Stage
I.
 The greatest output is at the end of Stage II.
 Therefore, Stage II is ideal, because there is a
balance between productivity and total output.
 Summary
 The Law of Variable Proportions states that
while varying only one input, output will go
through three stages:
 Increasing returns
 Diminishing returns (ideal)
 Negative returns
SHORT RUN PRODUCTION FUNCTION (with two variable factors)

Q = f(K,L)
K = CAPITAL, L = LABOUR

TWO AIMS:
-
Determining the minimum amount of variable factors need to produce a given
-
Quantity of output
-
- Determining the maximum quantity of output that can be produced for the geiven
-
quantities of inputs
ISOQUANT
- Represents a production function with two variable inputs

Shows a given amount of output produced by various combinations of two variable inputs
-

Shows all those combinations of two variable inputs which yield a given quantity of product

e.g
Q = f (K,L)

0L + 3K = 10Q
1L + 2K = 10Q
2L + 1K = 10Q
5L + 0K = 10Q
ISOQUANT MAP

OUTPUT = 10 OUTPUT = 20 OUTPUT = 30

K L K L K L

3 0 5 1 8 2

2 1 4 2 7 4

1 2 3 4 6 8

0 5 2 10 5 20
Substitutability of factors

PERFECT COMPLEMENTS

Two factors are prefect compliments if the increased use of one factor will require a
corresponding increase in the other variable. E. truck and driver
 PERFECT SUBSTITUTES

One factor can be easily replaced with the other

In reality, most of factors are not perfect complements of perfect substitutes

-
As K increases, substitutability of labour decreases
-
- As L increases, substitutability of capital decreases

There is DMINISHING MARGINAL SUBSTITUTABILITY

-
PROPERTIES OF ISOQUANTS
-
An isoquant must be negatively sloped

- An isoquant must be convex to the origin: because factors are not perfect substitutes
-

- Two isoquants cannot intersect each other

-

-
MARGINAL RATE OF SUBSTITUTION:
-
- Substitutability of one factor for another
-
- Given by slope of isoquant
-
Shows how many extra units of K must be employed to replace one last unit of L, if
output has to be maintained

MRTS (L for K) = change in K / change in L

-

-
MRTS shows relative productivity of two factors
-
If MRTS =1/2, it shows that to replace one unit of capital, you need two units of labour.
-
Therefore productivity of capital is twice as that of labour
ISOCOST LINE
An isocost denotes all combinations of inputs K & L which can be purchsed from the form’s
given budget funds
C = P(L)*L + P(K)*K
P(L)
P(K)
-
Firm will try to produce maximum output,
within its limited budget
-
It will produce where the isocost line is
tangent to the isoquant
Slope of Isoquant = Slope of Isocost
MRTS = P(L)/P(K)
or
MP(L)/MP(K) = P(L)/P(K)
or
MP(L)/P(L) = MP(K)/P(K)
RETURNS TO SCALE
Cobb-Douglas Production Function


Suppose that hamburgers are produced
according to the Cobb-Douglas function
q = 10K 0.5 L0.5

Since a+b=1  constant returns to scale

The isoquant map can be derived
q = 50 = 10K 0.5 L0.5  KL = 25
q = 100 = 10K 0.5 L0.5  KL = 100
 The isoquants are rectangular hyperbolas
Cobb-Douglas Production Function

The MRTS can easily be calculated

fL 5 L  0 .5 K 0 .5 K
M R T S (L fo r K )   0 .5  0 .5

fK 5L K L
 The MRTS declines as L rises and K falls
 The MRTS depends only on the ratio of K and
L